Draghi Gets Another Chance to Push ECB’s Forward Guidance

European Central Bank President Mario Draghi has struggled to convince financial markets that the forward guidance he unveiled two months ago has teeth.

He gets another crack at it on Thursday.

Bloomberg News

ECB President Mario Draghi

The ECB is expected to keep its main policy rate unchanged at 0.5%, a record low, following a report last month that the bloc’s economy exited a lengthy recession in the second quarter with annualized growth of 1.1%. Business surveys point to additional growth this quarter, with beleaguered southern European economies such as Spain and Italy showing signs of stabilizing.

That leaves the focus of Thursday’s monthly press conference on forward guidance. Two months ago, Mr. Draghi surprised financial markets by stating that the ECB board “expects the key ECB interest rates to remain at present or lower levels for an extended period of time.” That mixed forward guidance (extended period) with an explicit easing bias (interest rates at present or lower levels).

It was a communications U-turn from the ECB, which since its beginning in 1998 always said it didn’t precommit on rates. The apparent aim was to shield short-term euro zone interest rates from any volatility created by expectations on when the Federal Reserve would begin to taper its purchases of Treasury and mortgage bonds.

It worked for a short time, but money markets climbed further in July. Mr. Draghi firmed up the rate guidance last month, calling rate-hike expectations embedded in markets “unwarranted.” They’ve drifted higher since then, although money markets still only imply a first ECB rate hike in the latter part of 2015, economists say.

“I don’t think the problem is so much the level (of interest rates implied by markets),”said J.P. Morgan economist Greg Fuzesi. “It just looks like central banks want to keep control of the short end of the yield curve.”

But the ECB’s guidance is weak compared to other central banks. It hasn’t given explicit thresholds on inflation or unemployment, as the Fed does, to guide investors’ thinking. The ECB has already said it expects inflation to be well below its 2% target next year, at 1.3%, leading some analysts to question whether the ECB’s soft guidance really adds much information on how it will conduct its rate policy.

The simplest way to clear up any confusion would be to cut interest rates. That would show that the ECB is serious about its easing bias and that when officials say rate hike expectations are unwarranted, they mean it. But that would be hard to justify given the positive flow of economic news.

It could also do another round of long-term loans fixed to its policy rate to cement the forward guidance. But banks are repaying the three-years loans that the ECB doled out in late 2011 and early 2012, so there doesn’t appear to be a lack of liquidity.

That leaves more talk. At a minimum, Mr. Draghi is likely to reaffirm the existing guidance and continue to say that economic risks are tilted to the downside despite the recent good news. That would address any fears that the ECB would raise rates prematurely.

Mr. Fuzesi of J.P. Morgan said the ECB could further clarify its rate guidance by more explicitly explaining that modest growth won’t be inflationary, given the considerable slack in the economy. That would bolster hopes that inflation will remain significantly under 2% well into 2015 and further push back rate-hike bets.

“They should clearly say why inflation is staying as low as it is. Until they clarify that, guidance is going to always feel a little bit vague,” Mr. Fuzesi said.

About Real Time Economics

Real Time Economics offers exclusive news, analysis and commentary on the U.S. and global economy, central bank policy and economics. Send news items, comments and questions to the editors and reporters below or email realtimeeconomics@wsj.com.